F6:M1/M2 Leases: Part 1 & 2

At the inception of a "finance lease," the residual value expected to be owed at the end of the lease term should be:

included as part of the minimum lease payments at present value. -The residual value expected to be owed at the end of the lease term is, in effect, an ADDITIONAL LEASE PAYMENT and must be included in the calculation of the present value of the minimum lease payments. - Finance leases are valued at "present value" rather than future value.

Barnel Corp. owns and manages 19 apartment complexes. On signing a lease, each tenant must pay the first and last month's rent and a $500 refundable security deposit. The security deposits are rarely refunded in total, because cleaning costs of $150 per apartment are almost always deducted. About 30% of the time, the tenants are also charged for damages to the apartment, which typically cost $100 to repair. If a one-year lease is signed on a $900 per month apartment, what amount would Barnel report as refundable security deposit?

$500 - The entire $500 is recorded as a refundable security deposit. If the tenant moves out at the end of the lease term, the deposit is taken into revenue and matched with the cleanings costs and damage repair and/or refunded to the tenant. The deposit is NOT revenue upon receipt. --> The cleaning costs and costs for damages are only deducted from the security deposit until these costs are incurred.

What are the criteria for a lease to be classified as a "finance lease" in the books of a lessee under U.S. GAAP?

1) The lease contains a written purchase option. 2) The lease DOES transfer ownership of the leased property to the lessee at the end of the lease. 3) The lease term is EQUAL to the major part of the economic life of the underlying property (with 75% used as a minimum threshold). 4) The present value of the minimum lease payments is equal to, or substantially exceeds, the fair value of the underlying property (with 90% used a minimum threshold).

RULE: If any ONE of the following conditions is met, a lease is considered a "finance lease" under U.S. GAAP and is treated as if owned by the lessee

1. The lease contains a written purchase option. 2. The lease DOES transfer ownership of the leased property to the lessee at the end of the lease. 3. The lease term is EQUAL to the major part of the economic life of the underlying property (with 75% used as a minimum threshold). 4. The present value of the minimum lease payments is equal to, or substantially exceeds, the fair value of the underlying property (with 90% used a minimum threshold). 5. The asset is specialized such that there is no alternative use to the lessor.

Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, Year 1, and $50,000 annually on each December 31 for the next eight years. The present value on December 31, Year 1, of the nine lease payments over the lease term, using the rate implicit in the lease which Oak knows to be 10%, was $316,500. The December 31, Year 1, present value of the lease payments using Oak's incremental borrowing rate of 12% was $298,500. Oak made a timely second lease payment. What amount should Oak report as a lease liability in its December 31, Year 2, balance sheet? A. $243,150 B. $0 C. $350,000 D. $228,320

A. $243,150 The initial amount capitalized is the present value using the lessors' rate (implicit rate known to lessee - 10%). The following table shows the liability on 12/31/Year 2. Date Pymt Interest Decline in liability Liability 12/31/Y1 $316,500 12/31/Y1 50,000 - (50,000) 266,500 12/31/Y2 50,000 26,650* (23350)* $243,150 *12/31/Y2 $26,650 = (266,500 x 10%) --> Interest (23,350) = (50,000 - 26,650) --> Decline in liab.

Harris Inc. leased equipment under a finance lease for a period of seven years, contracting to pay $100,000 rent in advance at the start of the lease term on December 31, Year 1, and $100,000 annually on December 31 of each of the next six years. The present value at December 31, Year 1, of the seven rent payments over the lease term discounted at 10% (the implicit interest rate) was $535,000. Harris amortizes its liability under the lease using the effective interest method. In its December 31, Year 2, balance sheet, Harris should report a lease liability of: A. $378,500 B. $500,000 C. $391,500 D. $437,350

A. $378,500 - lease liability at 12/31/Year 2 PV at 12/31/Year 1 (start of $535,000 lease) of 7 pymts at 10% Less: down pymt at start of lease (100,000) EQUALS: liability under capital 435,000* (finance) lease at 12/31/Year 1 Less: pymt on 12/31/Year 2 $100,000 Less: 10% interest on PV of (43,500) liability (435,000* x 10%) Net pymt applied to principal (56,500) (100,000 - 43,500) EQUALS: Liability under capital $378,500 (finance) lease at 12/31/Year 2 (435,000 - 56,500)

Able sold its headquarters building at a gain, and simultaneously leased back the building. The lease was reported as a "finance lease" under U.S. GAAP. At the time of the sale, the sale-leaseback will be considered: A. A failed sale. B. Operating income. C. A separate component of stockholders' equity. D. A reduction of lease expense.

A. A failed sale. RULE: If the underlying lease in a sale-leaseback is a "finance lease," it is considered equivalent to a REPURCHASE and will therefore be considered as a "failed sale."

On January 1, a company enters into an operating lease for office space and receives control of the property to make leasehold improvements. The company begins alterations to the property on March 1 and the company's staff moves into the property on May 1. The monthly lease payments begin on July 1. The recognition of the lease expense for the new offices should begin in which of the following months? A. January B. March C. July D. May

A. January The lessee should begin the recognition of the lease expenses for the new office in January, as this is the commencement date (the date they received control of lease). - The commencement date is the date the underlying asset is made available to the lessee for use. Lease expense is recorded over the lease term.

As an inducement to enter a lease, Graf Co., a lessor, granted Zep, Inc., a lessee, twelve months of free rent under a five-year operating lease. The lease was effective on January 1, Year 1, and provides for monthly lease payments to begin January 1, Year 2. Zep made the first lease payment on December 30, Year 1. In its Year 1 income statement, Graf should report lease revenue in an amount equal to: A. One-fifth of the total cash to be received over the life of the lease. B. Zero. C. One-fourth of the total cash to be received over the life of the lease. D. Cash received during Year 1.

A. One-fifth of the total cash to be received over the life of the lease. Annual lease revenue equals the total lease revenue from the lease allocated over the full life of the lease. In this case, revenue equals total cash dividend by five years.

Which of the following statements regarding the lessor's accounting under an operating lease is most accurate? A. Income earned over the life of the lease is part interest and part principal. B. A refundable security deposit is booked as a liability until refunded to the lessee. C. Any applicable impairment charges to the leased asset will be booked by the lessee. D. Depreciation is booked over the life of the lease.

B. A refundable security deposit is booked as a liability until refunded to the lessee. In a operating lease: If a security deposit is refunded to the lessee, the lessor has to book the deposit as a liability until the point it is returned to the lessee (typically at the end of the lease).

A 20-year property lease, classified as an operating lease, provides for a 10% increase in annual payments every five years. In the sixth year compared with the fifth year, the lease will cause the following expenses to increase: A. Lease - No; Interest - Yes B. Lease - No; Interest - No C. Lease - Yes; Interest - Yes D. Lease - Yes; Interest - No

B. Lease - No; Interest - No No change in lease expense; no change in interest. RULE: The lessee shall record an operating lease as lease expense using the straight-line basis. Even though there is a variable payment, the payment is known at commencement of the lease term; therefore, the variable payments will be used in the calculation of the present value of the lease liability. There is no separately recorded interest component for an "operating lease."

Lease A does not contain a purchase option, but the lease term is equal to 90% of the estimated economic life of the leased property. Lease B does not transfer ownership of the property to the lessee by the end of the lease term, but the lease term is equal to 75% of the estimated economic life of the leased property. How should the lessee classify these leases under U.S. GAAP? A. Lease A - Operating lease; Lease B - Operating lease B. Lease A - Finance lease; Lease B - Finance lease C. Lease A - Finance lease; Lease B - Operating lease D. Lease A - Operating lease; Lease B - Finance lease

B. Lease A - Finance lease; Lease B - Finance lease BOTH leases have terms equal to or more than 75% of their estimated economic life; therefore, BOTH are finance leases under U.S. GAAP. RULE: If any ONE of the following conditions is met, a lease is considered a "finance lease" under U.S. GAAP and is treated as if owned by the lessee 1. The lease contains a written purchase option. 2. The lease DOES transfer ownership of the leased property to the lessee at the end of the lease. 3. The lease term is EQUAL to the major part of the economic life of the underlying property (with 75% used as a minimum threshold). 4. The present value of the minimum lease payments is equal to, or substantially exceeds, the fair value of the underlying property (with 90% used a minimum threshold). 5. The asset is specialized such that there is no alternative use to the lessor.

Assuming that no direct costs are involved, what are the components of the lease receivable for a lessor involved in a direct-financing lease? A. The minimum lease payments plus any executory costs. B. The minimum least payments plus residual value. C. The minimum lease payments less residual value. D. The minimum lease payments less executory costs.

B. The minimum least payments plus residual value. Lessors recording a lease receivable for a direct-financing lease should include the minimum lease payments PLUS any residual value. The reason for this is because the lessor can also expect to collect this residual value from the lessee at the culmination (peak) of the lease. --> Executory costs, like insurance, taxes, and maintenance, are always recorded separately and do not affect the computation of the minimum lease payments nor the lease receivable. --> The residual value needs to be ADDED, not subtracted, since the lessee is obligated to pay this to the lessor at the culmination of the lease.

Able Co. leased equipment to Baker under a noncancelable lease with a transfer of title. Will Able record depreciation expense on the leased asset and interest revenue related to the lease? A. Depreciation expense - Yes; Interest revenue - No B. Depreciation expense - No; Interest revenue - No C. Depreciation expense - No; Interest revenue - Yes D. Depreciation expense - Yes; Interest revenue - Yes

C. Depreciation expense - No ; Interest revenue - Yes Baker, the lessee, will capitalize the lease (due to the transfer of title) and will incur both depreciation and interest expense. Able will earn and book interest income when the payments for Baker are received. Able will remove the asset from its books at the inception of the lease and will not depreciate the asset.

At the beginning of the year, a lessee signs a five-year lease that contains a written purchase option, which the lessee is reasonably certain to exercise. In preparing the annual cash flow statements after year-end, the lessee's cash flow from operations will be: A. Positively impacted by the portion of the lease payments that represents interests. B. Positively impacted by short-term lease payments not included in the lease liability. C. Negatively impacted by variable lease payments not included in the lease liability. D. Negatively impacted by the portion of the lease payments that represents principal.

C. Negatively impacted by variable lease payments not included in the lease liability. Because this lease contains a "written purchase option" that the lessee is reasonably certain to exercise, it will qualify as a FINANCE LEASE (it meets the "W" criteria in "OWNES"). Variable lease payments not included in the lease liability are treated as cash flows from operations and will therefore have a negative impact on bottom-line cash flow from operations. --> The interest portion of the lease payments will serve to REDUCE cash flow from operations, as it is a "CFO" outflow.

If a lease meets at least one out of the five criterion to be considered a "finance lease" under U.S. GAAP, then it can be expensed or capitalized?

Capitalized! Only one criterion has to be met in order to capitalize. The lessee will capitalize the lease on its books.

Steam Co. acquired equipment under a finance lease for six years. Minimum lease payments were $60,000 payable annually at year-end. The interest rate was 5% with an annuity factor for six years of 5.0757. The present value of the payments was equal to the fair market value of the equipment. What amount should Steam report as interest expense at the end of the first year of the lease? A. $18,000 B. $0 C. $3,000 D. $15,227

D. $15,227 The finance lease will be recorded by debiting ROU asset and crediting lease liability for $304,542 ($60,000 minimum lease pymt x 5.0757 annuity factor). The interest expense in the first year will be calculated by multiplying the 5% interest rate x lease liability (principal): $304,542 x 5% = $15,227 --> Interest expense

Anton owns equipment originally purchased four years ago for $325,000. On January 1, Year 5, Anton sells the equipment to Bridges for $208,000. The equipment has a remaining useful life of six years, a carrying value of $195,000, and a fair value of $202,000. Bridges has agreed to lease the equipment back to Anton for three years with annual payments of $48,375 at an implicit interest rate of 5.25%. The lease qualifies as a sale. When the transfer takes place, Anton will record a financing liability equal to: A. $7,000 B. $13,000 C. $0 D. $6,000

D. $6,000 The difference between the sales price $208,000 and the fair value $202,000 is recorded as a financing liability on the books of the seller/lessee. Anton's JE: Debit: Cash $208,000 (sells equip) Debit: A/D equipment 130,000* Credit: Equipment $325,000 Credit: Financing liability 6,000 Credit: Gain on equipment sale 7,000 *Note the A/D (accumulated depreciation) on the equipment is derived by comparing the original purchase price of $325,000 with the carrying value of $195,000. ($325,000 - $195,000 = $130,000*)

On January 1, Year 1, Day Corp. entered into a 10-year lease agreement with Ward, Inc. for industrial equipment. Annual lease payments of $10,000 are payable at the end of the each year. Day knows that the lessor expects a 10% return on the lease. Day has a 12% incremental borrowing rate. The equipment is expected to have an estimated useful life of 10 years. In addition, the third party has guaranteed to pay Ward a residual value of $5,000 at the end of the lease. The present value of an ordinary annuity at $1 at: - 12% for 10 years is 5.6502 - 10% for 10 years is 6.1446 The present value of $1 at: - 12% for 10 years is 0.03220 - 10% for 10 years is 0.3855 In Day's October 31, Year 1 balance sheet, the principal amount of the lease obligation was: A. $58,112 B. $56,502 C. $63,374 D. $61,446

D. $61,446 - is the principal amount of the lease obligation in 10/31/Year 1 balance sheet. RULE: Lessee should use the "rate implicit in the lease" (if known by the lessee) to discuss cash flows. Annual lease payments $10,000 PV of ordinary annuity (10%, 10rs) x 6.1446 = Lease obligation $61,446 "rate implicit in the lease" --> Day knows that the lessor expects a 10% return on the lease. Note that the residual value of $5,000 is NOT included in the calculation of the lease obligation because it will be paid by a 3rd party and not by Day Corp. (the lessee).

Jay's lease payments are made at the end of each period. Jay's liability for a finance lease would be reduced periodically by the: A. Minimum lease payment. B. Minimum lease payment less the amortization of the related asset. C Minimum lease payment plus the amortization of the related asset. D. Minimum lease payment less the portion of the minimum lease payments allocable to interest.

D. Minimum lease payment less the portion of the minimum lease payments allocable to interest. - This represents the liability for a finance lease. RULE: For a finance lease, the minimum lease payment is allocated between principal and interest using the interest rate inherent in the lease. The portion allocated to principal reduces the remaining lease liability. The process is similar to a home mortage.

On January 1, Year 1, a shipping company sells a boat and leases it from the buyer in a sale-leaseback transaction. At the end of the 10-year lease, ownership of the boat reverts to the shipping company. The fair value of the boat, at the time of the transaction, was less than its undepreciated cost. Which of the following outcomes most likely will results from the sale-leaseback transaction? A. The boat will NOT be classified in property, plant, and equipment of the shipping company. B. The shipping company will recognize the total profit on the sale of the boat in the current year. C. The shipping company will NOT recognize depreciation expense for the boat in the current year. D. The shipping company will recognize in the current year a loss on the sale of the boat.

D. The shipping company will recognize in the current year a LOSS on the sale of the boat. GAAP requires that a LOSS to be recognized immediately in a sales-leaseback transaction when the fair value of the property at the time of the sale-leaseback is LESS than book value. Accordingly, the shipping company will recognize a loss in the current year because the fair value at the time of the sales-leaseback transaction was less than the undepreciated cost.

A six-year finance lease entered into on December 31, Year 1, specified equal minimum annual lease payments due on December 31 of each year. The first minimum annual lease payment, paid on December 31, Year 1, consists of which of the following?

Interest expense - NO; Lease liability - YES. The debt was incurred on December 31, Year 1. The initial payment was made on December 31, Year 1. - No interest expense is recognized since no time has passed between the debt that was incurred and the payment was made. - Thus, the full amount of the payment reduces the lease liability. --> Since no interest has accrued, no interest expense will be recognized. --> But, the annual lease payment (full pymt) reduces the lease liability.

What account is recognized in a finance lease?

Interest revenue - is recognized for a finance lease, based on the discount rate x carrying value of the lease receivable. As time passes, the lease receivable decreases and interest revenue recognized also decreases.

OWNES criterion for a "finance lease" under U.S. GAAP:

OWNES: O - OWNERSHIP of the underlying the asset transfers from the lessor to the lessee by the end of the lease term. W - WRITTEN option to purchase the underlying asset, the option is one that the lessee is reasonably certain to exercise. N - NET present value of all lease payments and any guaranteed residual value is equal to or substantially exceeds the underlying's assets' fair value. E - The term of the lease represent the major part of the ECONOMIC life remaining for the underlying asset. S - The asset is SPECIALIZED such that it will not have an expected alternative use to the lessor when the lease term ends.

A lessee had a 10-year finance lease requiring equal annual payments. The reduction of the lease liability in Year 2 should equal

The current liability shown for the lease at the end of Year 1. RULE: Finance leases should be recorded as both an asset and liability at the PV of the minimum lease payments. The asset is depreciated. The liability is amortized using the interest method. Each payment is allocated between principal and interest. The liability is reduced by the amount of principal reduction. The lease liability should be segregated between current (due within one year) and non-current (due beyond one year). Accordingly, the reduction in lease liability each year is equal to the current liability at the end of the previous year.